Elements Of Safety In Bonds
( Originally Published 1918 )
(Courtesy Harris Trust and Savings Bank.)
The average person perhaps does not realize to what an extent he is now indirectly investing in bonds, and enjoying the advantages which bonds have made possible. The insurance company in which he, his family or his property is insured invests its funds largely in bonds. So very likely to a considerable degree does the bank in which he deposits his money. The school where he sends his children has probably been built from the proceeds of a bond issue, as have many of the other public improvements of 'his community, the railroads which developed the country nearby, the trolley lines on which he rides, etc. Many of the greatest conveniences of the present day would have been impossible if bonds had not been considered safe investments by a very large number of people of means.
There comes to almost every prosperous man a time when he wishes to know the best way of securing a steady income from his accumulated savings without the burden of responsibility of managing property in order to gain this income. The merchant may not wish to put back into his business all the earnings he gets from it. The farmer realizes how soon his broad acres may be run down through soil-robbing when he rents his property "on shares." When such a problem arises the thoughtful man casts about him for information on which to act.
One of the first things he learns, if he studies the situation carefully, is that there is a wide difference between an income derived from one's own business ability, such as the profit secured from running a store, factory, jobbing house or farm, and the income which is the result of money "working" by itself. In the first case, one must keep up his business responsibilities; in the other, once he has selected a safe investment, practically all he has to do is to collect his income from time to time as it falls due. There is no depreciation of land, buildings, machinery or the like; no insurance to worry about; no crop failures to consider.
Investment Advice. If one wishes to put surplus money away say the proceeds from the sale of a business or a farm and to get a steady income from it without bother and worry, the most important thing to consider is how to go about it to select something which, once purchased, will turn out to be a safe investment.
Safety is the First Consideration. This means only one thing: the sum of money you invest must be returned to you or your heirs in full at some definite time. Every safeguard to this end must be provided. You should not be satisfied with the mere ownership of property without definite assurance of the return of the money you put into it. This is just as true whether the property be in the form of a partnership in a going business, the stocks of a corporation, or pieces of real estate. No one is obliged to take these off your hands, and if you are to get back the money you have invested you must sell in whatever market you can find for the property.
On the other hand, if you lend your money, it must be returned to you at a certain time, and you do not have to sell property in an uncertain market to regain what you have invested. From this you can see that a safe investment is not merely property, but it is a secured promise to pay an obligation to return, for value received, a certain sum of money on a given date.
But the desirability of an investment does not end with the obligation to return the principal; the sum must provide beyond question a satisfactory income. This should not be as uncertain as the profits from the individual ownership, let us say, of real estate, for lands or buildings may be idle and the income cease. Neither should it depend upon the rise and fall of the profits of a business, as when dividends on stocks of corporations increase or stop entirely as the company enjoys prosperous times, or suffers reverses. Such methods of employing capital are of their very nature business risks, requiring skill of management to assure an income. If you wish to free yourself from these risks and responsibilities, provision must be made to have the income of a safe investment fair, steady and as certain as human foresight can make it.
Security. In the old common law sense of the word, a bond signified an obligation to perform an act, and in the event of failure so to do, there was provision for the forfeit of something to compensate for damages sustained. This is true of investment bonds, which are secured by a lien against property which would be forfeited in case the obligation were not met.
In the case of Government and Municipal bonds there is no direct lien against property, but there is a lien against taxes levied upon property and, as everyone knows, taxes must be paid or else property is forfeited. Therefore, all investment bonds are secured either directly or indirectly by a lien against property. The return of the principal sum at a definite date and the regular payment of interest at a fixed rate are set forth in special agreements in the bond, which also usually provide penalties in case the agreements are not carried out.
In short, when a successful investor wishes to avoid risk he has in mind three important requisites of any investment he may choose :
First : Security, or safety of the principal invested.
Second : Ready convertibility into cash in case a change of investment be desired, or ready money needed.
Third: As high a rate of interest as can be obtained without sacrificing steadiness of income or safety of principal.
An Ideal Investment. An ideal investment must have the qualities of convertibility. That is, it should be of such character and in such form as to permit of ready sale for cash if this should be desired, or of its use as collateral for a loan at a bank in case the investor needs to borrow money quickly. In this great age of public improvements and general business on a huge scale requiring large sums of capital, money is borrowed for such projects in large amounts. At the same time, in order that these loans may be available to all owners of money, large or small, a big loan, or bond issue, is divided into many smaller parts, and one of these parts is a bond.
For example: an issue for one million dollars may be divided into one thousand parts, or bonds, of $1,000 denomination each; or perhaps 2,000 bonds of $500 each, or even 10,000 bonds of $100 each. In other words, such a bond issue may be compared to a huge farm mortgage, divided into many parts, each part like a separate mortgage. Therefore, a bond is a negotiable instrument, so prepared as to be readily recognized at banks and in the market places of the world as a part of a loan of real worth and definitely secured as to re-payment of principal with interest.
A bond is a specially prepared document, usually engraved or lithographed on very fine paper, so that it will not wear out with years of handling. The wording on the bond states just what the bond is; when the promise to pay will fall due; where the principal is payable, and in what kind of money; when, where and how the interest is to be paid, and how much it is; and what the provision is for the prompt payment of principal and interest.
The Coupon is a small ticket-like division. The reading matter on such coupons states that so many dollars of interest on the bond for a year or half-year or quarter year will be due on a certain date and will be payable at the place indicated. When these coupons fall due, the owner of the bond clips them off and presents them for payment. If he is some distance from the place of payment he may collect his interest by mail, or, more easily, he may deposit his coupons at any bank for collection.
Some bonds do not have coupons; these are known as "fully registered bonds." Instead of presenting coupons for collection, the owner of such bonds receives his interest by check through the mail without action on his part. To "register" a bond the owner has it sent to the agent of the maker of the bond so that he may be re-corded as the owner of the bond. Bonds may be registered in two ways. In the case of a "fully registered" bond both principal and interest are payable only to the person who has been recorded as its owner. Thus, a "fully registered" bond may be said to be "registered as to principal and interest." When, however, a bond is "registered as to principal only," it carries interest coupons, which are collected in the usual way. A bond, the principal of which is registered, must be transferred on the books of the maker's agent each time it is sold; that is, only the registered owner can sell it legally.
Coupon bonds can be sold without this formality. The chief value of the registered form of bond is that it safeguards the bondholder against loss in case the bond is mislaid or stolen. If the purchaser expects to sell his bond on short notice, it is preferable to buy the coupon form instead of the registered form, for the coupon bond can be delivered at once without the delay some-times necessary in transferring the registered bond.
Its Maturity. We have said that on the face of the bond is printed the date it will fall due, or be paid off. This date is its maturity. Many bonds are paid off at a stated date, without any privilege of payment at an earlier time. Such bonds may run for any period specified, but it is customary for them to run ten, twenty, thirty, forty, fifty years or longer. Some bonds, however, have provision for the payment on a sped-fled date and also an option of being paid off at an earlier date. Thus a bond with a maturity of twenty years from date of issue may, by such provision, be retired in ten years.
The Rate of Interest. The rate of interest to be paid is stated in the bond, and also the time when the interest will fall due, whether every three months, every six months, or yearly. This rate is paid until the bond matures or is redeemed under its optional provision. The usual interest payment is semi-annual; thus the owner of a bond bearing five per cent interest payable semi-annually January 1 and July 1 will receive on each of those dates a half-year's interest on his bond; if the denomination of the bond is $1,000, that is $1,000 face value, he will receive $25 on January 1 and $25 on July 1.
Since interest is always accruing on bonds at the rate named therein, one must consider, when bonds are sold, the amount of interest that has been earned between the time the last previous coupon was cut off and the date the bonds are to change hands. Naturally the seller of the bonds wishes to profit from the interest the bonds have earned while they were his; hence he charges the buyer with this "accrued interest." From this practice arises the term "and interest," or "and accrued interest" in connection with the market price of a bond. The price of a bond, therefore, is usually quoted thus: "97 1/2 and interest." This means that a $1,000 bond is to be sold at $975, plus whatever interest has been earned on the coupon that will next fall due; or that a $100 bond will be sold at $97.50 and interest. To cite an exact example :
Suppose interest on a certain $1,000 bond is payable January 1 and July 1 at the rate of five per cent yearly, and the bond is to be sold October 1; it is evident that a coupon calling for $25 was paid July 1, but that the next coupon to be paid January 1 has earned half the $25 to be paid next January. In other words, $12.50 has accrued to the date of sale. Therefore, if the bond is to be sold at 971/2 and interest, the price will be $975 plus the $12.50 accrued interest, or $987.50. Thus the seller gets his accrued interest on his bond when he sells it, and the buyer gets back the interest thus advanced when the coupon matures in January.
The Price of a Bond. The price of a bond means the amount for which it is sold, and, like the price of grain, provisions or any other commodity, depends upon market conditions existing at the time. Naturally, other things being equal, a five per cent bond will bring a higher price than a four per cent bond, because the income of the five per cent bond is greater. But the security behind the four per cent bond may be so much greater than that behind the five per cent bond that the four per cent bond will be more attractive, therefore in greater demand and commanding a high market price. Besides these two considerations there is the general question of the prevailing price of money in the markets of the world; in other words, general interest rates. If the rate of a bond is higher than general money rates, that bond becomes very desirable. Thus, these influences taken together may cause a bond to sell for more or less than its face value, or for exactly that amount (par). That is, one kind of a $1,000 bond may be so attractive that it may sell for $1,080; or as the price would be quoted in percentages, at 108 (at eight per cent premium, or eight per cent above par). Another $1,000 bond may be, for entirely legitimate reasons, less in demand and sell for $900; or in market terms, at 90 (at ten per cent discount, or ten per cent below par).
Income on Investment. There may be a marked difference between the rate. of interest paid and the rate of income on the investment in a bond. The rate of interest is always the same, but the rate of income which the investor secures from his investment in a bond varies ac-cording to the price paid, the interest rate specified and the length of time the bond has to run. When a bond is sold below its face, or par, value, in other words at a discount, the rate of income is naturally more than the fixed rate of interest named in the bond, because the interest is figured on the face value and the investor has not paid the full face value for the bond.
On the contrary, when a bond is sold at a premium, or above its face value, the rate of income derived from the investment naturally is less than the rate of interest named in the bond.